Past performance may be an illusion: Performance, flows, and fees in mutual funds

Transcription

1 Past performance may be an illusion: Performance, flows, and fees in mutual funds Blake Phillips, Kuntara Pukthuanthong, and P. Raghavendra Rau September 2014 Mutual funds report performance in the form of a holding period return (HPR) over standardized horizons. Changes in HPRs are equally influenced by new and previously reported stale returns which enter and exit the horizon. Investors appear unable to differentiate between the joint determinants, reacting with equal strength to both signals. Stale performance chasing is amplified for funds which promote performance via advertising and is more pronounced during periods of uncertainty in financial markets. Fund managers exploit this behavior by preferentially timing fee increases to align with periods of heightened investor demand resulting from stale performance chasing. Keywords: Limited attention; Behavioral finance; Investor psychology; Capital markets; Horizon Effects; Mutual fund fee-setting * Phillips: School of Accounting and Finance, University of Waterloo, 200 University Avenue West, Waterloo, Ontario, N2L 3G1, Canada, (519) , Pukthuanthong: Robert Trulaske Sr. College of Business, University of Missouri, Cornell Hall, Columbia, Missouri, USA 65211, (573) and Rau: University of Cambridge, Trumpington Street, Cambridge CB3 9LR, UK, (44) (1223) , Phillips gratefully acknowledges financial support from the School of Accounting and Finance at the University of Waterloo, PricewaterhouseCoopers and the Social Sciences and Humanities Research Council of Canada. We would like to thank Neil Brisley, Joe Chen, Susan Christoffersen, Mike Cooper, Javier Gil-Bazo, Will Goetzmann, Russell Jame, Petri Jylha, Jonathan Reuter, Laura Starks, William Stroker, Ivo Welch (Editor), Tony Wirjanto, Jeff Wurgler, three anonymous referees and seminar participants at the 2012 Annual Meeting of the Academy of Behavioral Finance and Economics, the 2012 Northern Finance Association Conference, the 2013 SFS Cavalcade conference, the 2013 European Finance Association meetings, the 2013 Financial Management Association meetings, the 2013 Inquire UK conference, and the University of Waterloo for helpful comments.

2 Past performance may be an illusion: Performance, flows, and fees in mutual funds Mutual funds report performance in the form of a holding period return (HPR) over standardized horizons. Changes in HPRs are equally influenced by new and previously reported stale returns which enter and exit the horizon. Investors appear unable to differentiate between the joint determinants, reacting with equal strength to both signals. Stale performance chasing is amplified for funds which promote performance via advertising and is more pronounced during periods of uncertainty in financial markets. Fund managers exploit this behavior by preferentially timing fee increases to align with periods of heightened investor demand resulting from stale performance chasing. Keywords: Limited attention; Behavioral finance; Investor psychology; Capital markets; Horizon Effects; Mutual fund fee-setting

3 Singer Tom Petty once warbled that the waiting is the hardest part. Now that wait is finally over for many mutual-fund managers. That is because 2007 marks a milestone that could greatly help their funds: It will have been five long years since the late-2002 bear-market bottom. This means that five-year performance numbers no longer will reflect the market's steep slide. Instead, they will capture the market's upswing since then. Funds took the brunt of the dot-com bust at different times. January 2002, for instance, was a particular low for Old Mutual Focused Fund, which had a sinking, large position in Adelphia Communications Corp., a cable company that eventually filed for bankruptcy-court protection. "I'm very anxious to roll off that quarter specifically," says Jerome Heppelmann, manager of the fund. Its five-year annualized return has more than doubled to 6.4% through December 2006, compared with a 2.8%-a-year gain at the end of Introduction One of the most persistent and robust patterns documented in the mutual fund literature is return-chasing by investors. 2 The disproportional allocation of wealth to funds with superior performance in prior periods transcends mutual fund asset classes, country boundaries, and investment objectives. Given the limited evidence of persistence in mutual fund performance (Berk and Green, 2004), this trend is largely described in the popular press as irrational. For example, on the heels of the 1999 bull market, concerns regarding the potentially detrimental impacts of returnchasing led then Securities and Exchange Commission (SEC) Chairman Arthur Levitt to caution investors against this practice, stating Chasing fund performance is often the quickest way to hurt your mutual fund returns. 3 In this paper, we examine a different type of return-chasing behavior. Without exception, the return-chasing literature has focused on investor reaction to the most recent fund return. We analyze whether investors chase stale fund returns, returns arising from horizon effects in holding period returns (HPR), the standard format of performance reporting. Due to either naïvety or 1 Diya Gullappalli, The mutual-funds eraser, Wall Street Journal, January 26, For example, Barber, Odean and Zheng (2000) report that over half of all fund purchases are of funds ranked in the top quintile of prior annual returns. Also see Ippolito (1992); Chevalier and Ellison (1997); Sirri and Tufano (1998); Lynch and Musto (2003) and Karceski (2002). 3 SEC press release , New SEC mutual fund tips remind investors to look at more than short-term past performance. -1-

4 limited attention, investors appear unable to distinguish between the new and stale components of changes in HPRs when making allocations, and misconstrue the changes in returns as new information regarding manager ability and future fund performance. We document how this stale return-chasing effect is used by funds to attract investor allocations and set fees and argue that this type of behavior is part of a general class of horizon effects that have implications for other areas of finance including the asset pricing literature. Specifically, when advertising past performance, Rule 482 of the Securities Act of 1933 requires investment companies to report past performance in the form of an HPR over horizons of 1, 5, and 10 years for funds in existence over those horizons. The horizon must be at least one year long and must end with the latest calendar quarter. These requirements are designed to standardize performance reporting across funds and ensure that fund managers are not selecting arbitrary horizons to maximize their reported performance. Investment companies are free to report other horizons as long as their prominence is not greater than the required horizons. In particular, as a matter of convention, mutual funds typically also report the 3-year HPR, perhaps because mutual fund rating agencies such as Morningstar or Lipper also rank funds on the basis of their past 1, 3, 5, and 10 year HPRs. The focus of our analysis is how investors interpret the change in reported HPRs. For example, consider the following 5 quarter return time series: Period Return -2% 3% 4% 5% -4% The annual HPR for quarters -2 to -5 is 8% and the corresponding annual HPR for quarters -1 to -4 is 10%: Even though the fund experienced a negative return in the most recent period (t=-1), the HPR increased as the end-return which dropped from the sample was more negative. The change in the HPR is therefore a function of the most recent return (-2%) which enters the horizon and the end- -2-

5 return (-4%) which drops from the horizon. As all other intervening returns are common in the return sequences, they have no influence on the change in the HPR. Thus, the change in HPR is influenced only by new information (reflected in the most recent fund return), and stale information (reflected in the end-return that was reported to investors four quarters previously). As illustrated by the introductory quote, mutual fund managers appear to view the stale information component impounded in the change in the HPR as an important influence on investor behavior. The manager quoted is anxious to roll off a quarter with particularly poor performance. In other words, the manager anticipates an improvement in the fund s reported performance because a negative end-return drops from the horizon of the HPR calculation. However, the improvement in the reported HPR implies only that immediate performance was less negative than the quarter being rolled off. After controlling for the most recent return, the change in the HPR does not provide any new or relevant information regarding future fund performance. To our knowledge, the extent to which stale returns influence investor behavior has yet to be explored. If investors have access to the entire time series of fund returns, the change in the HPR can easily be decomposed into new and stale information components. It is plausible that at least some investors have access to this information. Our analysis spans the period of 1992 to 2010, during which the availability of mutual fund information expanded dramatically, evolving from paper disclosures by mutual funds to the SEC to electronic availability of mutual fund disclosures and related data via EDGAR and data providers such as Morningstar. However, we argue that they do not necessarily use this information. Hirshleifer and Teoh (2003) argue that investors have limited attention and processing power and potentially lack the sophistication to interpret the disclosed information. In our setting, regardless of the availability of past returns, investors are overwhelmed by the volume of public information available to assess mutual fund quality and thus gravitate to information that is presented in a salient, easily processed form. Further, it is not clear that the average retail investor understands the manner in which HPRs are calculated and consequently the influence of stale information when evaluating the time series of HPRs. The computation procedure is not reported and only investors with some level of finance education would understand the nuances of performance reporting. -3-

6 We document three results in the paper. First, analyzing investor allocations, we find that investors appear unable to differentiate between the new and stale information components of performance reported by mutual funds. It is well understood that investors chase past performance, allocating disproportional wealth to funds with strong recent performance. Our results suggest that investors react with equal vigor to the stale information component of HPRs. In other words, investors direct disproportionate flows to funds which realize improved HPRs due to end-returns dropping from the horizon of HPR calculations. Second, mutual fund managers specifically cater to and exploit this behavior by advertising end-return related improvements in reported performance. Third, mutual fund managers also align fee increases with periods of artificially heighted fund demand resulting from end-return related increases in performance, harming existing investors who pay higher fees for the same fund and potentially leaving new investors worse off. Specifically, examining the universe of actively managed, domestic mutual funds in the U.S., we first show that investors react to the stale information component in HPRs. In separate regressions, we relate measures of mutual fund capital allocations and redemptions in month t to fund return in month t-1 (new information) plus, in sequence, each of the other monthly return lags up to lag 73 (stale information). For example, the first regression includes the fund returns in t-1 and t-2 as independent variables, the second regression includes the fund returns in t-1 and t-3 as independent variables, and so forth across 72 separate regressions. This approach allows us to decompose investor reaction to the change in HPR into new and end-return components. We then exploit differences in visibility of different return lags. Given that mutual funds are constrained to report HPRs over specific horizons, investor sensitivity to end-return effects should manifest only for lags specific to those horizons (specifically the 13 th, 37 th, and 61 st return lag in our setting, relating to the 1, 3, and 5 year HPR). If investors are influenced by horizon effects, controlling for the new information conveyed by the return from period t-1, we expect those specific return lags to be associated with large and negative allocations to mutual funds, as the removal of an observation from the HPR calculation has an inverse effect on the magnitude of the HPR. -4-

7 This is precisely what we find. On average, mutual fund investor allocations are more than twice as sensitive to return observations realized 13, 37, and 61 months prior than in other months and the coefficients on these return lags are all significantly negative. Although flow sensitivity to lagged performance is non-zero for many lags, only the coefficients for the 13 th, 37 th, and 61 st return lags are also consistently statistically different from the average sensitivity to lagged performance. Further, the magnitude of investor sensitivity to these return lags is of equal or greater magnitude to return-chasing on the first return lag. Investors appear unable to recognize the influence of time on HPR calculation horizons and direct disproportionate flows towards funds which benefit from the statute of limitations expiring on prior poor performance. We refer to this as stale return chasing. Stale return chasing behavior is consistent with incentives created by advertising. We show that mutual funds preferentially promote high HPRs and time advertising to periods when the 1, 3, and 5 year horizon HPRs are coincidentally high. This might not appear to be surprising since funds would be expected to selectively promote high returns. However, controlling for these incentives, we find that advertising spending is incrementally higher when the fund has benefited from end-return related improvements in HPRs. In other words, mutual funds appear to preferentially promote performance measures that arise from poor returns dropping off the end of the reported horizon. This is also not entirely surprising. It is easier to time advertising around predictable improvements in HPRs, resulting from negative end-returns dropping from the HPR horizon. These can be anticipated well in advanced and allow time for campaign development. Of course, future HPRs cannot be perfectly forecasted as they are equally influenced by the new return (which cannot be predicted) and the end-return which can be perfectly anticipated. However, as discussed in the introductory quote, in instances when the end-return is sufficiently large and negative, a relative improvement in HPRs can be easily foreseen. In additional results, we find that the horizon effect is more pronounced for funds with greater marketing expenditures and the effect is most pronounced for fund-specific advertising that features HPR information or horizon specific rankings. -5-

8 In the final part of the paper, relating the total expense ratio of the fund to our stale performance effect measures and controls, we find that mutual funds time fee increases by reducing waivers to coincide with periods of positive performance caused by negative end-returns dropping from the HPR horizon. A one standard deviation increase in the stale performance signal is associated with a 20% increase in the fund s expense ratio. The cost to newly attracted investors is hard to quantify as we are unable to observe the counterfactual choice what investors would have purchased if they did not purchase this fund. Fee increases are incrementally higher when investor demand arises from stale performance signals. Unreported tests show that future fund performance is unrelated to stale performance chasing. However, existing investors are clearly harmed, paying higher fees for the same fund. In addition, this behavior distorts competition between mutual funds for investor allocations, rewarding managers who generate administrative costs running uninformative advertising. Our results contribute to the growing literature on how investors with limited attention react to information. Cooper, Gulen, and Rau (2005) argue that investors are influenced by cosmetic effects. They show that mutual funds attract flows by changing their names to the current hot style with little underlying change in portfolio holdings. Barber, Odean, and Zheng (2005) argue that the purchase decisions of mutual fund investors are influenced by salient, attentiongrabbing information. Investors buy funds that attract their attention through exceptional performance, marketing, or advertising. We show that investors also react to apparent increases in performance which occur as a function of horizon effects in the required reporting form. The most novel contribution of our paper, however, is the examination of opportunistic behavior by managers. There is limited evidence in the literature on the channels through which managers take advantage of behavioral biases. Li (2008) shows that annual report readability is related to earnings persistence as the annual reports of firms with lower earnings are harder to read. He argues that this is consistent with managerial incentives to obfuscate information when firm performance is bad (also see Bloomfield, 2002). Mullainathan, Schwartzstein, and Shleifer (2008) develop an uninformative persuasion model where individuals think coarsely, grouping situations in categories and applying the same models of inference to all situations in the same category. -6-

9 They show that persuaders take advantage of coarse thinking by framing objectively useless information to influence individual s choice of category. Bertrand, et al. (2010) argue that advertising content persuades by appealing peripherally to intuition rather than reason. Our research provides new evidence on how and when mutual funds use uninformative information (i.e. stale performance signals) to persuade investors that they are high-performance or quality funds. Palmiter and Taha (2012) argue that performance advertising by mutual funds is inherently and materially misleading, violates federal securities antifraud standards, and takes advantage of naïve investors. Provisions under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act require further intervention by the SEC. 4 To our knowledge, we are the first to document evidence consistent with funds planning advertising campaigns based on stale performance information and then strategically increasing fees to exploit return-chasing based on stale information. Our results are broadly consistent with mutual fund performance advertising misleading investors who do not appear to appreciate the influence of horizons on reported fund performance. Finally, our results may offer an economic mechanism to explain the horizon effects found in the asset pricing literature. It is well known in that literature that high stock returns in a month tend to forecast high stock returns 12-, 24-, and 36-months ahead (Jegadeesh, 1990, Heston and Sadka, 2008, 2010, Goyal and Wahal, 2013). While these papers do not explain why these effects appear to be most significant at annual return horizons, they may be related to investor reactions to reported performance at those horizons. 4 Specifically, the Act requires the Government Accountability Office to conduct a study on mutual fund advertising to identify (1) existing and proposed regulatory requirements for open-end investment company advertisements, (2) current marketing practices for the sale of open-end investment company shares, including the use of past performance data, (3) the impact of such advertising on consumers, and (4) recommendations to improve investor protections in mutual fund advertising and additional information necessary to ensure that investors can make informed financial decisions when purchasing shares. See the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 918, 124 Stat. 1376, 1837 (2010). -7-

10 2. Literature Review and the General Setting Mutual funds are predominantly held by individual investors. In 2012, 44% of US households held mutual funds and 89% of US mutual fund assets were held by households. The median income of households which invest in mutual funds was $80,000 and 68% of those households held over 50% of financial assets in mutual funds. 5 Thus, the typical mutual fund investor is an individual with limited time, whose professional training is likely focused on a nonfinancial field, and who potentially lacks the expertise to make investment selections. Due to the large number of funds available and the wealth of information provided by investment companies, analysts, and other investors via social networks, it is plausible that investors have only limited attention to devote to picking an appropriate mutual fund. Evaluating the merits of an actively managed mutual fund involves assessment of the asset picking and market timing ability of the manager as well as the inherent risk exposures of the fund s assets. Individual investors must allocate attention to work and personal life, in addition to making investment decisions. Directing attention to a specific task requires effort and necessitates exclusion of other tasks (Fiske, 1995) and tends to be directed to information that is more vivid or salient (i.e. which is more prominent or which stands out). 6 Further, the manner in which attention is allocated depends on the ease with which relevant instances come to mind (availability heuristic, Kahneman and Tversky, 1973). In our setting, HPRs feature extremely prominently in mutual fund advertising and analyst reports and are likely perceived as readily comprehensible by investors, thus being appealing both in terms of salience and availability. A sample mutual fund advertisement appears in panel A of Figure 1, providing a sense of the prominence of the HPR. Interpreting the returns disclosed in the advertisement, an investor may perceive that fund performance has steadily improved (reflected by the 1 year relative to the 3 year HPR). Beyond contrasting adjacent horizons, investors may also contrast changes in common horizons across timeframes (i.e. comparing the 1 year HPR in 5 See the 2013 Investment Company Institute Fact Book, 53 rd Edition. 6 For example, Amir (1993) reports that footnote disclosure of post-retirement benefits are underweighted by investors. See also the discussion by Fiske and Taylor (1991). -8-

11 the current and previous quarters). However, as previously discussed, given the information in the advertisement, it is impossible for the investor to discern if the higher 1 year performance is due to a low end-return dropping from the 1 year horizon or strong recent performance. To disentangle the new and stale information components impounded in the reported HPRs, investors must access higher frequency return data. This requires a greater allocation of attention, assuming the investor is sophisticated enough to understand the need for such additional effort. There is evidence that even sophisticated investors, such as analysts, are influenced by the form and prominence of financial disclosures. For example, Hand (1990) reports abnormal reaction to re-announced gains from debt-equity swaps in quarterly earnings announcements and Plumlee (2003) finds that analyst s revisions of forecasts of effective tax rates reflect less complex tax law changes but not more complicated information. Thus, even if investors understand the nuances of HPR reporting, framing or inattention may lead to misinterpretation of reported mutual fund performance. 3. Measuring Investor Reaction to Stale Performance We obtain mutual fund data from the Center for Research in Security Prices (CRSP) Mutual Fund Database. Our sample commences in 1992, when CRSP consistently begins reporting monthly frequency total net asset (TNA) values and concludes in December The CRSP database provides monthly TNA and returns by fund share class as well as quarterly or annual disclosures of management and 12b-1 fees, front and back end loads, portfolio turnover, and fund management objectives. We aggregate multiple share classes of the same fund, weighting returns, fees, loads and portfolio turnover by share class TNA, and focus our analysis on actively managed, domestic equity funds. 7 The early part of the time series of our dataset ( ) includes on average 1,774 funds, provided by 470 separate investment companies (fund families) with a combined TNA of 1.0 trillion USD. Our dataset expands to include on average 3,093 funds, To identify actively managed mutual funds, we use the list of actively managed funds from Cremers and Petajisto (2009) available from Antti Petajisto s website -9-

12 families, and a combined TNA of 3.7 trillion USD in the later part of the data time series ( ). To measure the stale performance effect, we relate proxies for investor allocation preferences to the first return lag plus successive return lags (n=2 to 73), in 72 separate regressions: (1) where n signifies the lag of the second return included as an independent variable in month t. The primary measure of investor preferences is the change in market share held by the fund, defined as:,,, (2) where, is total net assets under management for fund i in month t, and is aggregate total net assets for all funds in the sample at time t. We use the change in market share as our primary investor preference proxy as Spiegel and Zhang (2013) argue that the more commonly utilized proxy, net flow, fails to consider the effect of aggregate investor allocations when testing the flowperformance relation. Chalmers, Kaul, and Phillips (2013) show that investors react to macroeconomic indicators in unison when allocating flows across mutual fund asset classes. Flowperformance models which fail to control for correlated flows across funds of the same type may be misspecified. To further control for correlated investor allocations across time or fund, when estimating equation (1) we cluster standard errors by fund and date (month-year). A disadvantage with market share measures is that a fund market share might increase if it holds securities that increase in value even if they do not attract or lose any new investors due to stale return roll off. For example, if a fund holds 30% of its allocation in IBM and IBM triples in a month, this fund s market share is likely to increase, even absent any new flows. Hence, in Panel B, we also report the same regression as in equation (1) but using net flow as our dependent measure. (3) Net flow is defined as:,,,,, -10- where flow for fund i in month t is calculated as the percentage change in TNA while controlling for return (R) effects. The intuition

13 behind this measure can be illustrated with a simple example. Suppose a fund has a TNA value of $500 in period t and its rate of return is 5% over the coming month. In the absence of any changes in investor behavior, the fund TNA will be $550. Hence, a TNA value of $580 in period t+1 implies that net inflows were $30. These net inflows should be subject to stale return chasing, not the increase in TNA, $50, due to the return earned by the fund. For robustness, we also replicate our analysis using net sales (sales less redemptions excluding dividend reinvestment) collected directly from fund N-SAR filings and provided by Morningstar. We note that using the traditional Fama-MacBeth (FM) type regression specification is inappropriate in our analysis. The FM approach assumes serial non-correlation and strong crosssectional correlations. This is plausible when the dependent variable is a return but not when it is an inflow or on outflow. As previously discussed, to motivate our use of equation (1) and (3), we note that the change in HPR has only two influences, the magnitude of the return in the current period and the magnitude of the end-return which drops from the calculation. These two returns have an equivalent impact on the HPR, though only the former is new information. Modeling investor response to the change in HPR, it then follows that mt (or Flowt) becomes a function of the new and end-return, linearly approximated by equation (1). All intervening returns are common between adjacent HPRs and have no influence on ΔHPR. If investors interpret the stale information component of the change in HPR as information regarding future fund performance, we expect the βn coefficient related to return observations at the end of standard HPR reporting periods to be negative. This relation follows from the inverse relation between the magnitude of the end return which drops from the sample and the change in the HPR. 4. Do investors chase stale returns? The βn coefficients from the pooled, OLS regression series in equation (1) and associated t-statistics are reported in Panel A of Table I. As discussed, mutual funds are required to report HPRs in set intervals of 1, 5, and 10 years and reporting the 3 year HPR has become convention. -11-

14 Given the length of our sample, we focus on the first three intervals. Thus, the variables of interest in Table I are the magnitudes and signs of the 13 th, 37 th, and 61 st monthly return lag. The first reported t-statistic (Reg. t-stat) tests if the coefficient is significantly different from zero. We note that there are several coefficients, apart from the coefficients of interest, that are also statistically significant (examples include β4, β6, or β7). It is plausible that the random allocation activity of investors causes the coefficients for certain return lags to be different from zero. Hence, we implement a standard placebo test, randomly allocating returns to investor allocation observations with and without replacement and replicate equation (1). In the placebo tests (reported in Table A1 of the online appendix), a similar number of return coefficients are statistically different from zero, reflecting an inherent level of noise in investor preferences and the estimation of their relation with returns. In addition, although we have no specific priors that investors should use other return lags when directing allocations, we do not exclude the possibility that future research will uncover further relations between return lags and investor allocations. The significance of other return coefficients may also reflect these unknown relations. Hence, we also report a difference t-statistic (Diff. t-stat) below the regular t-statistic testing if the return coefficient is different from the absolute mean coefficient, which is the value arising from random allocations by investors. Since the average absolute return coefficient value in Panel A of Table I is 0.145, the difference t-statistic tests the null hypothesis Ho: Rn = average Rn = We find that the coefficients related to the 13 th, 37 th, and 61 st return lags are larger than all but one of the other coefficients. 8 The average absolute value of these three coefficients is 0.35, twice the size of the absolute mean coefficient (significant at the 5% level). With the exception of the Rt-14 and Rt-18 coefficients, none of the other coefficients are significantly different from both zero and the absolute mean of the coefficient sample (α=10%). 9 In particular, the 25 th, 49 th, and 73 rd return lag coefficients, which relate to the 2, 4, and 6 year HPRs, are not significantly different from the absolute mean (t-statistics 1.51, 0.41 and 1.15, respectively). It is also noteworthy that 8 The R t-14 is larger than the R t-61 coefficient (-0.29 versus -0.28) but is smaller than the R t-13 and R t-37 (-0.33 and -0.43, respectively). 9 Using an alpha value of 5%, only the 13 th and 37 th return lags are different from the absolute mean coefficient. -12-

15 the magnitudes of return-chasing on the lags of interest are of equal or greater magnitude to returnchasing on the first return lag (the average coefficient value on the first return lag in equation (1) is 0.31). Investor asset allocations appear equally or more sensitive to the stale information reflected in HPR end-returns relative to the new information reflected in the most recent return. Our conclusions are qualitatively similar when we use equation (3) using net flow, as an alternative proxy for investor preferences. The coefficients are reported in Panel B. We note that in particular, the Rt-14 and Rt-18 coefficients are no longer significantly different from the absolute mean. To provide a sense of economic scale, a one standard deviation shift in Rt-1, Rt-13, Rt-37, or Rt-61 is associated with a 2.0%, 1.7%, 2.2% and 2.7% shift in flow (net sales or redemptions as a percentage of fund TNA). It is also noteworthy that some coefficients are consistently negative (though not always significantly different from the absolute mean of the sample). These are typically months right around annual horizons and at semi-annual horizons. For example, Rt-6, Rt-12, Rt-14, Rt-18, Rt-24, and Rt-25 coefficients are all usually significantly negative. Our results pertain to investor responses to stale returns, not managerial responses. It is likely that there are other significant patterns in past returns that affect investor behavior that we have not isolated. Whether these patterns in investor responses to past returns are related to asset pricing anomalies documented in the literature, is likely to form an interesting extension to this paper. We next implement a series of robustness tests and extensions to the base model, which are reported in Panels C and D in Table 1 and in Table A2 of the Online Appendix. As previously discussed, only the most recent return and the end-return which drops from the sample influence the change in HPR and our focus is to determine if investors differentiate between these two sources of changes in HPRs. For this reason, we exclude intervening returns from the stale returnchasing model in Panel A. The alternative hypothesis to stale performance chasing is that investors observe the full time series of returns and make asset allocation decisions after considering all available returns. Under this alternative hypothesis, stale performance chasing should not be observed as the investor can easily decompose the change in HPR into current and stale information components. In Panel C, we replicate Panel A, but estimate the coefficient on each -13-

16 return lag simultaneously in one pooled regression, in essence assuming that investors observe and adjust allocations jointly based on all 73 return lags (equation (4)). (4) Our conclusions are unaffected. The coefficient estimates are similar between Panel A and C. The average value of the β13, β37, and β61 coefficients is relative to in Panel A. The Rt-14 coefficient is no longer statistically different from the average absolute coefficient in the joint model though Rt-6 and Rt-7 become statistically different. We also report a more parsimonious version of equation (4) in Panel D where we also include Rt as an additional coefficient, and obtain largely similar results. The remainder of the extensions and robustness tests are reported in Panel E and in Table A2 of the online appendix. In the interest of brevity, only the coefficients of interest are reported in Panel E (the full output is reported in Table A2). For ease of comparison, coefficients from Panel A are reported in Panel E as model (1). Across all our tests, the β13, β37, and β61 coefficients are the only coefficients that are consistently significantly different both from zero and the average. In model (2) we jointly cluster by fund, fund family and time as investor allocations may be correlated at the family level. Clustering on the additional family dimension does not alter our conclusions. All three coefficients remain significant at the 1% level. However, investor allocations are likely to be influenced by a range of factors beyond prior fund performance. In the base specification earlier, controls for investor preferences were not included. This is because if the determinants of stale return chasing are also the determinants of investor preferences, this joint influence will cause our stale performance chasing estimates to be understated. 10 Cognisant of this potential conflict, in model (3), we replicate equation (1) adding the following controls commonly used in the mutual fund literature (all measured at the end of period t-1): change in market share, fund TNA, fund age, family TNA, number of funds in the fund family, standard deviation of monthly fund returns over the prior year, expense ratio, portfolio turnover, Morningstar rating, and the change in Morningstar rating. Expense ratio and portfolio turnover are 10 For example, investors that prefer larger funds may also be more prone to react to stale return signals. Hence including fund size as a control will cause stale performance chasing to be understated. -14-

17 calculated as the percentage of TNA charged as expenses and the percentage of TNA traded per annum, respectively. Overall, our conclusions are unaffected. As expected however, the addition of controls diminishes the size of the stale return chasing coefficients. In particular, the magnitude of the Rt-61 coefficient decreases from to and the coefficient is no longer statistically different from the absolute coefficient mean. The Rt-13 and Rt-37 retain both their significance and remain statistically different from the absolute mean, the only coefficients to do so. The majority of the shift in the magnitude of the Rt-61 coefficient appears to be caused by including fund expenses and portfolio turnover. Unreported tests show these variables also determine the magnitude of the stale return chasing coefficient from Panel A, causing the stale performance chasing effect to be understated in model (3). Next, we seek to differentiate between stale performance chasing at the fund and objective level. To do so, we estimate equation (1) with the addition of fund objective fixed effects (model 4). In this model specification, though two of the three coefficients of interest diminish in size, all three coefficients remain statistically different from the absolute mean (α=10%). This result suggests that majority of stale performance effect occurs based on fund level and not objective level returns. Jointly augmenting equation (1) to include both objective fixed effects and controls generates coefficients of interest largely on par with the estimates in Panel A (model 5). It can be argued that seasonal activities undertaken by funds, such as window dressing or dividend payments will bias our estimates. For example, funds predominantly pay dividends in December and the majority of investors instruct the fund to automatically reinvest dividends. 11 Since CRSP adjusts returns to include dividends, returns are bolstered in December for dividend paying funds and NAV will increase by the reinvested dividend amount. It is important to recognize that our model inherently controls for seasonal effects, as returns are not necessarily calendar aligned as the return series for each fund starts at inception which may occur at any time. Thus, for example, Rt-13 is not inherently a December return for all funds. 11 In the 2011 Factbook, the Investment Company Institute reported that investors reinvested $173 out of $202 billion USD paid in dividends (86%). Examining the payment period in the CRSP database, 20% of dividends are paid in December, with remaining dividends spread evenly over the remaining months with the exception of small increases in frequency at the end of calendar quarters. -15-

18 To mitigate concerns related to seasonal effects, we use three approaches. First, we replicate our models after clustering by month. Since our results remain robust to this approach, we do not report these results for brevity. Second, we utilize total sales and redemptions from the N-SAR filings of each fund available from Morningstar. This alternative data source enables the direct calculation of investor preferences (sales redemptions) from which we exclude re-invested dividends. Using net sales (model 6), the significance of the coefficients of interest improves. Third, we exclude January returns from the sample and replicate the model (Model 7, Table 2A of the Online Appendix) and find similar results. Finally, we report several specifications in Table A2 in the Online Appendix to answer additional questions. We emphasize that these are largely ad hoc specifications which are not driven by theory. First, do investors react to raw returns or market-adjusted returns? To answer this question, in Model 8, we estimate the model using returns in excess of the return to the SP500 Index. Our results are largely unaffected by this adjustment with this model generating results broadly consistent with model 4 of Panel E in the main paper. Second, is the relation symmetric? In other words, are the results driven only by negative returns dropping from the sample? Coefficient estimates reported in Table A2 Model 9 are estimated after replacing each negative return with 0, thus eliminating negative returns from the return history. We find significant effects when positive returns are dropped from the sample, implying that the relationship is symmetric. In particular, the Rt-13, Rt-37, and Rt-61 retain their significance though not surprisingly, given the ad hoc nature of this analysis, a few other variables such as Rt-45 also become significant. Finally, in Table A2 Model 10, we examine if the effect is non-linear in general. We sort each coefficient of interest Rt-13, Rt-37, and Rt-61 into terciles and report the β coefficients for the three regressions separately. The magnitude of the stale return chasing effect does appear to increase strikingly when the most negative returns drop off from the sample. However, we still find a significant returnchasing relation even when the highest returns drop off from the sample, consistent with the results reported in Model 9. We note that our results are sensitive to the choice of sub-period. As we discuss below, the prominence to investors of HPR changes is influenced by time varying manager behavior. More -16-

19 importantly, large improvements in HPRs result from large negative returns dropping from the horizon of analysis. HPR changes are hence realized in cascades, with a large negative return dropping from the 1 year horizon first, impacting the 3-year HPR 2 years later and finally affecting the 5-year HPR after an additional two years have passed. For example, consider the period immediately after the dotcom bubble (referred to in the introductory quote). Funds that were exposed to the end of bubble decline in 2002 will not realize 5-year effects in their returns till Thus, the average effects we report in Table 1 are not realized in all sub-periods but are observed to vary across the time series as a cascade or wave. This may also give the impression of steadily improving performance (see Figure 1 Panel A) and encourage investors to invest. In sum, these results provide strong evidence of mutual fund investors chasing stale performance. Mutual fund allocations are more sensitive to lagged returns associated with the end of commonly reported HPR periods. These findings are consistent with mutual fund investors observing changes in HPR values and interpreting these changes as new information regarding future fund performance. 5. Does fund advertising take advantage of stale return chasing behavior? We use two proxies for fund marketing expenditures. First, following Sirri and Tufano (1998), we use the 12b-1 expenditure of the fund. The 12b-1 fee is a noisy proxy. Although described as being levied to cover marketing and distribution expenses, only approximately 2% is used for promotion or advertising. 12 Although a relatively small proportion of the 12b-1 fee is directed at advertising, it is still used in prior research as a reasonable proxy for the general marketing effort of the fund. Our second proxy for marketing expenditure is investment company advertising data compiled by Kantar Media (KM). KM is an advertising consulting firm which makes available compendiums of advertising activity in all U.S. media outlets. Although KM collects data for all 12 The balance is used for advisor initial sales incentives (40%), ongoing shareholder services (52%) and underwriting fees (6%) (ICI, 2005). -17-

20 advertising mediums, our data is limited to print media (newspaper and magazine) advertising, which Reuter and Zitzewitz (2006) report accounts for 65% of total investment company advertising expenditures. The KM dataset includes estimates of advertising expenditures based on advertisement size, placement, and periodical. This data is summarized monthly by investment company and periodical from 2005 to In addition, for the magazine advertisements, a PDF copy of each advertisement is supplied. A detailed description of the advertising dataset construction process appears in the online appendix. In total, 123 magazines and 3 newspapers appear in the dataset. Examples include common finance periodicals such as the Wall Street Journal, the New York Times, Barron, and Bloomberg Business Week in addition to magazines with other focuses such as Bon Appetit, Coastal Living, or Rolling Stone. 144 unique fund families advertise at least once in the dataset. The magazine portion of the dataset features 2,355 unique advertisements, many featured in multiple magazines over multiple months. Table II presents summary statistics for the advertising dataset. On average, investment companies spent 264 million USD on print media advertising annually. Spending typically increases annually, on average by 16% year-over-year, with the exception of 2008 to 2009 when advertising expenditures dropped by 31%, coinciding with the start of the mortgage backed security (MBS) crisis. On average, 66% of advertising expenditures were directed at magazines relative to newspapers. These values are broadly consistent with Reuter and Zitzewitz (2006) who note that, on average, from 1996 to 2002 investment companies spent 199 million USD per year on print media advertising, with a 60:40 proportion between magazines and newspapers. To provide a sense of the objective of investment company advertising, we partition the magazine advertisements by focus. Investment companies provide a range of products and services in addition to mutual funds, such as exchange traded funds, retirement plans, or other types of investment plans. On average, only 32% of advertising undertaken by investment companies directly promotes mutual funds. Of the advertising focused on promoting mutual funds, on average, 31% focused on general promotion of the fund family, while the other 69% promoted one or more specific funds. 39% of fund specific advertising promoted the HPR of the featured funds. Rankings by mutual fund rating agencies such as Morningstar, Lipper, or Barron are commonly -18-

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